As I have expressed countless times on my blog, youtube, and twitter, a huge portion of my trading strategies derive from one simple concept. Probabilities. Whenever you enter a position, whether it be a long term investment, or a very short term speculative activity, you are subject to simply random chance and probabilities. So with this realization, as successful market participants, our goal should be to put the probabilities in our favour. How do we accomplish this? The best way to do so in my opinion is by initiating positions with favourable reward to risk ratios. Essentially, whenever we make a trade or investment, we need to make sure that what we stand to lose is less than what we can potentially make from the position. Consider this: if we were to take only trades that are accompanied with a 4:1 reward to risk ratio (we risk $1 to make $4), we can be wrong 70% of the time on market direction, and still make money in the end. Observe some of the greats in the financial management/hedge fund industry. You will notice that this simple concept is present in their successes.
Utilizing this Concept in the Market Today
Currently, the stock market has seen what would be called a “volatility crush”. A volatility crush is when a market’s volatility basically contracts significantly in a very short amount of time. Large contractions in volatility usually come before a large volatility expansion, typically caused by some outside shock to the financial marketplace. The beautiful aspect of a volatility contraction is that when we take a position in the “crush” environment, we know very quickly when we are wrong (the market will move very powerfully out of these ranges). This allows us to have a smaller stop, long or short, with a larger reward.
At this point in time, it is safe to say that the stock market has effectively priced in global central bank accommodation to risk-markets, as expressed by the recent rise in stock prices and volatility contraction (indicating market participants feel “safe”). Due to this “pricing-in” of global events, with a bias to the upside, an external shock to the downside would most likely cause a much larger move lower as the majority of the market is long at this point (traders who are long will need to liquidate). With this in mind, we can assume that a move lower will see more movement, and more potential.
Based upon this information, the better reward to risk trade in my opinion right now is to be short equities, and long volatility. Have a different opinion or would like to add to the discussion? Comment below!
Marchese Financial 